Is Shareholder Activism The Cure For The Common Stock?

Includes: APA
by: Ertan Enginalev

The number of companies targeted by activist investors has risen significantly over the past years while activist hedge fund investment returns consistently outperform the average hedge fund.

Critics argue activist investing fosters short-termism by preventing corporate management from making long-term investments needed for sustainable growth.

Activist engagements are becoming increasingly more sophisticated in scope and strategy.

Shareholder activism and company responses to it have changed considerably since Benjamin Graham launched his activist engagement at Northern Pipe Line Co. in 1926. Likewise, the number of companies targeted by activist investors has risen significantly over the past years while shareholder activism in all its forms and myriad strategies continues to spread to new international territories. And with investment returns consistently outperforming the average hedge fund, a growing number of asset managers are poised to follow the lead of high profile activist investors such as Nelson Peltz, William Ackman, and Daniel Loeb, in their pursuit to create shareholder value.

Critics of activist investors argue that their strategies foster short-termism by preventing corporate management from making long-term investments needed for sustainable growth. While it is true that activist investors like quick returns, this is an actuality that applies to almost all institutional investors. The quicker the return on a realized investment, the higher the Internal Rate of Return and the faster the investment funds can be re-invested for subsequent gains. But just because activist investors understand basic Internal Rate of Return math does not mean that quick short-term results are the sole objective of their investment decisions.

Quite to the contrary, if share prices are supposed to reflect the discounted present value of a company's future income stream, which incorporates the market's best guess as to the future value of a company's shares, the market would deliberately factor in any activist induced short-termism by heavily discounting all future earnings estimates. Put another way, the share price of the target companies would decrease, reflecting the market's expectation that the company's future prospects and profitability will be bound to take a turn for the worse.

With that in mind, a recent study by Lucian Bebchuk, Alon Brav, and Wei Jiang, discovered that save for a few exceptions, the target companies' valuations, including return on assets and operating performance, improved in the five-year period following an activist engagement. Moreover, three years after the partial or full cashing out of an activist investor's stake, long-term shareholders still had positive returns.

The reality is many activist investors advocate strategies that require substantial time to implement. In addition, most experienced activist investors understand that time frames can be fickle and prone to change between an initial proposal for a change at the target company and the actual acceptance and implementation of the change by management. Hence, a significant number of activist investors undertake investments with durations measured in years not months.

Moreover, to successfully engage, activist investors need to persuade other investors to support their plan for corporate change seeing that the majority of activist investors are minority shareholder, holding a small percentage of a company's shares while the greater part is owned by institutional investors. Without their vote, any shareholder activism engagement would be short-lived.

While poor capital allocation decisions by target companies may have been a key driver behind many shareholder activism engagements in the recent past, dividend payout and share buyback strategies are bound to lose their appeal in the face of significant appreciation in stock market valuations. In light of this, activist engagements are becoming increasingly more sophisticated in scope and strategy. Unfortunately, the prevailing wisdom of target companies is that dealing with an activist investor is like running an election campaign. And like election campaigns, proxy contests have a long history of demonstrating the value of negative campaigning.

In short, if the mere mention of an activist investor compels you to fire up the torches, seize the pitchforks, and man the perimeter, it is high time to take into account that creating shareholder value in the short-term should not in itself be reason enough to condemn shareholder activism outright as long as the strategies laid out by the activist investor do not destroy more value in the long-term for the sake of short-term gains.

After all, this type of 'hit-and-run' investment approach would not be in the interest of any investor with a medium to long-term investment horizon least of all mutual and pension funds with the sway to make or break an activist engagement. Trying to predict which companies' activist investors will target next can be complicated; investing in a target company after an activist engagement has been disclosed, on the other hand, can be downright hazardous.

Successful activist engagements often take time to materialize, as the market evaluates the credibility of the activist investor and the willingness of management to engage. In addition, it is important to consider the average cost of the activist investor in order to evaluate the risk/reward merits of any potential investment sufficiently. One should never take a position based solely on the strength of an activist investor's track record without a satisfactory understanding of the investment's underlying margin of safety.

Take for example Apache Corporation (NYSE:APA). It might be tempting to follow in the footsteps of Barry Rosenstein. Shares gained almost 5% and closed at $103.12 up from $98.56 after Jana Partners disclosed a $1 billion stake in the U.S. energy company on July 22nd. Even so, this would have not been the time to rush in.

The shares of target companies have a tendency to increase 5-6% in the days just before and after an activist engagement is publicized. However, more often than not, these gains do not prove to be permanent in the short term. As in the case of Apache Corporation, the shares of the company have been hovering around $101 as of July 28th.

As impatience and fatigue sets in, the patient value investor will find ample opportunities to build a position with a favorable risk/reward profile following the initial market excitement. The key is to seek out shareholder value, not momentum trading opportunities.

As to Jana Partners, based on the information disclosed in their 13F, it did not own any shares in Apache Corporation at the end of last quarter when the company was trading around $80, but my best guess based on the information reviewed is that their average cost is around $88 to $92. However, one will get a more accurate perspective into their position once Jana Partners makes its filings with the U.S. Securities and Exchange Commission.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.